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Tax reform could spell trouble for derisking

David Wilson anticipates a ‘substantial deficit’ in the long-duration bond market.

Updated with correction

Potential effects of the new U.S. tax law have stoked concern among some industry sources that corporations might issue fewer long-duration bonds, making it tougher for corporate pension plans looking to derisk.

For plans that hit their liability-driven investment glidepath triggers and want to increase derisking, "you're currently able to buy bonds," said David Wilson, managing director, head of solutions design, Nuveen LLC, Chicago. "But we do project a substantial deficit going forward" as more plans hit their derisking marks and look for long-duration investment-grade corporates to hedge liabilities.

There's already been a decline in corporate bond issuance, according to data from the Securities Industry and Financial Markets Association. Issuance year-to-date April 30 totaled $597.8 billion, down 13.9% from the same period last year.

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Changes to the U.S. tax code, enacted in late 2017, cut the corporate rate to 21% from 35% and could lead to less corporate debt being issued, increasing the imbalance between supply and demand, according to a report by investment consultant Willis Towers Watson PLC, "Pension funds and tax reform: How to deal with a double-edged ​ sword."

"(Fixed-income) issuance has tended to be inversely related to interest rates," said the report, released late last month. "Therefore, the combination of rising rates and a lower corporate tax could deter companies from issuing debt. While these dynamics may not take effect immediately, over the long term there is reason to believe that companies could deleverage as a result."

"Long term, I agree with Willis Towers Watson, there'll be less motivation going forward to issue long-duration corporate debt," said Nuveen's Mr. Wilson. "There's less of a tax-deduction incentive to (issue debt), which will have a negative impact on the long end of the curve.

"And along with that, it's expected there will be significantly higher rates from the Federal Reserve. … As rates rise, liability rates fall, so you'd expect more plans to hit their glidepaths to derisk at a time when issuance is falling. ... We do expect a lack of supply for late entrants into hedging."

The new tax law also will allow companies to make tax-deductible plan contributions under the 2017 rate until Sept. 18, saving the companies further on their overall taxes. That, Mr. Wilson said, will have even more corporate plans hitting their derisking triggers, creating yet more demand for long corporate bonds.

Always meet demand

Others disagree and believe the market will always meet demand for long-duration fixed income or that intermediate-duration debt will replace demand for longer bonds as plans move closer to full derisking and reduce their overall liability duration.

Ryan Brist, portfolio manager and head of global investment-grade credit, Western Asset Management Co., Pasadena, Calif., said the Willis Towers Watson paper provided valuable insight, but makes the assumption that DB plans will all rush into long-duration fixed income all at once.

James So, LDI specialist at Western Asset, added there won't be a such a rush because it would require plan sponsors to lower their assumed rate of return as more assets are shifted to lower-return investments like bonds as funding improves. "Chief financial officers hesitate on that," he said. "They are on the derisking train, but there's pushback from CFOs on lowering the rate of return because that has a direct effect on the income statement."

Said Mr. Brist, "Fears of a shortage of long-duration fixed income are probably overblown. The tax law will have an effect on the margins, but the smart decision for corporate treasurers and CFOs is to utilize the tax law to fund their pensions. It's an aggressive assumption that those same treasurers and CFOs would look to fully fund their pensions in the near future ... We believe the U.S. credit markets are far more developed than elsewhere. Wall Street is very good at creating products to fill demand. If there's a great demand for 30-year corporates, capacity will go up."

Justin Harvey, vice president and multiasset solutions strategist, T. Rowe Price Group Inc., Baltimore, said he doesn't foresee the long-duration capacity crisis everyone expects. Investment-grade credit issuance in the first five months of this year is 89% of the issuance in the same time span in 2017, with a total of $206 billion in 2018 vs. $231 billion in 2017, Mr. Harvey said, citing Barclays PLC data. "Yes, that's less, but it's a very choppy market to begin with," Mr. Harvey said. In January of this year there was $73 billion in investment-grade credit issuance but $24 billion in March, he said, citing Barclays data.

"That's obviously less," Mr. Harvey said, "but not to the extent where everyone needs to run to the hills."

Mr. Harvey said the drop in issuance is happening "at the front end of the curve, the one- to three-year points of the curve. That's where you could see the effects of the swings on repatriation and tax cuts. That's not as significant for LDI issuers, because they predominantly use duration that matches their liabilities, and they need maturities of 10 to 12 years. A shift in the one-year portion of the yield curve has little effect because you're only discounting one year of cash flows, it's not compounded over the duration of the liability."

Nuveen's Mr. Wilson agreed that intermediate-duration fixed income has no capacity restraints, but the ability to use those bonds in a derisking strategy depends on how far along the path to full derisking a plan sponsor is. "If the liability is matched with intermediates, it's an option," Mr. Wilson said. "But is the plan mature with a shorter duration or younger with a longer duration? It depends where you are."

Among other options for duration, Messrs. Brist, Wilson and Harvey all agreed private credit is far better as a return-seeking investment than as a liability hedge because of issues involving duration matching and illiquidity.

"We caution against" private credit, WAMCO's Mr. Brist said. "We're long in the tooth in the credit cycle. It may not prove smart to go down there in general and with illiquidity this late in the cycle."

What can be used

Western Asset suggests taxable and tax-exempt municipal bonds and parts of the mortgage market can be used in a derisking strategy, Mr. Brist said, while Mr. Harvey at T. Rowe Price said LDI clients have used 30-year Treasuries and STRIPS — fixed-income securities sold at a discount to face value with no interest payments because they mature at par. He also said taxable municipal bonds and sovereign bonds "have a mature profile with more pension fund liability cash flows."

Mr. Wilson said he endorses taxable muni bonds in LDI strategies, "which have a higher correlation to corporates and have less historical losses than them as well."